Related Search

Interest rates: are investors in for a nasty shock?

Has the market become too complacent with its expectations for a "slow and low" increase in the interest rate cycle? History tells us that forecasts have a habit of not turning out quite as planned.

15/12/2015

Keith Wade

Chief Economist & Strategist

Risk of rising interest rate

The threat of a dramatic rise in interest rates seems unlikely.

Market consensus remains that any rate rises will be fairly modest and that the peak will be much lower than in past cycles.

We broadly adhere to that view, but we think investors still need to be prepared for much sharper rises than expected.

The conditions are there. They include, amongst other things, a number of emerging economies heavily dependent on external borrowing and unprecedented quantities of “electronic money” created through quantitative easing (QE) which is currently not reaching the real economy.

While the possibility of significant rate rises is not an active threat right now, any catalyst will come as a surprise.

Investors need to be alive to the risk and some may want to take protective measures.

What drives higher rates?

Historically, two major factors have led to a rapid and significant increase in interest rates: accelerating price inflation and capital flight.

Inflation

Price inflation, and in extreme cases hyperinflation, can be caused by large government deficits financed by the printing of money rather than taxes or borrowing.

QE has had a similar effect. There has been a rapid increase in money supply but it has not been supported sufficiently by growth.

That has created an imbalance between the demand and supply of money, which can lead to rapid inflation.

Periods of high inflation can also be caused by extreme supply shocks, like the oil crises of the 1970s which then triggered a wage-price spiral.

Most of the rate hikes we looked at between 1975 and 1988 were attempts to curb high inflation rates, but led most developed countries into recession at the turn of the 1980s.

Capital flights

Capital flights occur when investors suffer a crisis of confidence in a country's ability to service its debts.

Typically this situation involves a country with a chronic balance of payments deficit and a fixed exchange rate.

As investors lose faith they sell the currency, forcing the country to devalue or to raise interest rates to prevent further flights.

We saw this recently in China where authorities devalued the currency as investors became nervous about the country’s massive debts.

In fact, in terms of defending currencies, we found that the biggest interest rate hikes have been in emerging markets, whose economies have more vulnerable external accounts, which often rely heavily on volatile commodity prices and have suffered frequent crises.

Emerging markets, of course, are not immune to inflation problems either.

It is worth noting that inflation and exchange rates are closely related.

For example, the fear of high inflation in a country can lead to capital flight which in turn causes the currency to depreciate.

The falling exchange rate can quickly lead to increased inflationary pressures as import prices rise.

Where do risks lie today?

Taper Tantrum

The first is a possible replay of the “taper tantrum” of 2013 (when bond yields surged in response to the then Federal Reserve (Fed) Chair Ben Bernanke suggesting a tapering of QE), when (and if) the Fed raises interest rates later this year.

Emerging economies, despite reducing their external financing requirements, are the most at risk. Some developing economies look more vulnerable than others.

Brazil, Russia, South Africa and Turkey have already suffered big drops in their exchange rates in anticipation of the US rate rise.

There are early signs that this is feeding through to higher inflation rates, and some central banks have already raised interest rates to counter inflationary pressures.

Underestimating inflation and the impact of QE

In today’s deflationary environment this may seem a distant prospect, with prices actually falling in several regions.

However, the decline has been driven by a one-off fall in energy prices, the impact of which will lessen over time.

The danger is that Fed misjudges the build-up of pressure and tightens too late.

This could be the result of the liquidity created by QE bursting out into the real economy like a dam breaking, creating a flood of liquidity that causes prices to accelerate sharply.

One of the biggest issues with QE is that its longer term effects are untested and one of the unknown factors with QE is precisely when its impact will be felt. Central bankers are operating in the dark in this respect.

In the absence of past experience, there are no empirical studies or economic models which give an answer.

Extraordinary circumstances

A more sinister scenario is if the extraordinary measures taken by the authorities to avoid destructive deflation – such as QE – become difficult to reverse.

Achieving a “Goldilocks” level of inflation (just enough but not too much) is not easy.

In such circumstances, it may prove hard to avoid the sort of hyperinflations seen in the past, such as those in Germany in the 1920s or Brazil in the 1980s and 1990s.

The possibility of a significant rise in rates, though not central to our forecasts, therefore deserves consideration.

Topics:

Related content

We review a turbulent year for the global economy which endured dramatic falls in the price of oil, geopolitical tension in Europe, a stockmarket crash in China and ends with the Federal Reserve considering raising interest rates for the first time in nearly a decade.

The views and opinions contained herein are those of Schroders Investment Team and do not necessarily represent Schroder Investment Management North America Inc.'s house views. These views are subject to change.

This article is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument mentioned in this commentary. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but Schroder Investment Management North America Inc. (SIMNA) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions. Past performance is no guarantee of future results. Sectors/regions mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/sell.

Schroder Investment Management North America Inc. is an indirect wholly owned subsidiary of Schroders plc and is a SEC registered investment adviser and registered in Canada in the capacity of Portfolio Manager with the Securities Commission in Alberta, British Columbia, Manitoba, Nova Scotia, Ontario, Quebec, and Saskatchewan providing asset management products and services to clients in Canada. This document does not purport to provide investment advice and the information contained in this newsletter is for informational purposes and not to engage in a trading activities. It does not purport to describe the business or affairs of any issuer and is not being provided for delivery to or review by any prospective purchaser so as to assist the prospective purchaser to make an investment decision in respect of securities being sold in a distribution.

Schroders has expressed its own views and opinions in this document and these may change. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. Schroder Investment Management North America Inc. (“SIMNA Inc.”) is an investment advisor registered with the U.S. SEC. It provides asset management products and services to clients in the U.S. and Canada including Schroder Capital Funds (Delaware), Schroder Series Trust and Schroder Global Series Trust, investment companies registered with the SEC (the “Schroder Funds”.) Shares of the Schroder Funds are distributed by Schroder Fund Advisors LLC, a member of the FINRA. SIMNA Inc. and Schroder Fund Advisors LLC. are indirect, wholly-owned subsidiaries of Schroders plc, a UK public company with shares listed on the London Stock Exchange.

Further information about Schroders can be found at www.schroders.com/us.